Practical4,560,0002,4001,900. 00 Normal4,560,0001,2003,800. 00 Master-budget4,560,0001,4403,166. 67 The rates are different because of varying denominator-level concepts. Theoretical and practical capacity levels are driven by supply-side concepts, i. e. , “how much can produce? ” Normal and master-budget capacity levels are driven by demand-side concepts, i. e. , “how much can we sell? ” (or “how much should we produce? ”) 2. In order to incorporate fixed manufacturing costs into unit product costs, fixed manufacturing costs have to be unitized for inventory costing.
Absorption costing is the method used for tax reporting and for financial reporting using generally accepted accounting principles. The choice of a denominator level becomes relevant under absorption costing because fixed costs are accounted for along with variable costs at the individual product level. Variable and throughput costing account for fixed costs as a lump sum, expensed in the period incurred. 3. The variances that arise from use of the theoretical or practical level concepts will signal that there is a divergence between the supply of capacity and the demand for capacity.
This is useful input to managers. As a general rule, however, it is important not to place undue reliance on the production volume variance as a measure of the economic costs of unused capacity. 4. Under a cost-based pricing system, the choice of a master-budget level denominator will lead to high prices when demand is low (more fixed costs allocated to the individual product level), further eroding demand; conversely it will lead to low prices when demand is high, forgoing profits.
This has been referred to as the downward demand spiral—the continuing reduction in demand that occurs when the prices of competitors are not met and demand drops, resulting in even higher unit costs and even more reluctance to meet the prices of competitors. The positive aspect of the master-budget denominator level is that it indicates the price at which all costs per unit would be recovered to enable the company to make a profit. Master-budget denominator level is also a good benchmark against which to evaluate performance. -40(20 min. )Cost allocation, downward demand spiral. 1. = = Budgeted denominator level=2,920,000 meals WHM is using budgeted usage as its denominator level for calculating the budgeted fixed costs per meal in 2007. 2. Alternative denominator levels include: a. Capacity available. The data in the problem note that the facility can serve 3,650,000 meals a year. With this denominator level, there will be budgeted unused capacity, which could be recorded as a separate line in the cost report for the Santa Monica facility. . Budgeted usage of capacity. With the 2007 budgeted usage of 2,920,000 meals, the fixed costs charge is $1. 80 per meal. The marketplace is signalling that WHM’s own central food-catering facility is not providing value for the costs charged. If Cheung decides to raise prices to recover fixed costs from a declining demand base, he will likely encounter the downward demand spiral: Budgeted Denominator(1)| Variable Cost per Meal(2)| Fixed Cost per Meal$5,256,000 ? 1)(3)| Total Cost per Meal(4)| 3,650,000| $4. 56| $1. 44| $6. 00| 2,920,000| 4. 56| 1. 80| 6. 36| 2,550,000| 4. 56| 2. 06| 6. 62| 2,000,000| 4. 56| 2. 63| 7. 19| Cheung might adopt a contribution margin approach, which means viewing the $4. 56 variable cost as the only per-unit cost and the $5,256,000 as a fixed cost. Alternatively, Cheung could use practical capacity to cost the meals and work to reduce costs of unused capacity. 3. Three factors managers should consider in pricing decisions: a. Customers.
Cheung is facing customers who are dissatisfied with both the cost and the quality of the meal service. Three of the 10 hospitals have already elected to use an outside canteen service. b. Competitors. For the three hospitals terminating use of the Santa Monica facility, at least one competitor is more cost-effective. The seven remaining hospitals likely will be very interested in how this competitor performs at the three hospitals. c. Costs. Jenkins should consider ways to reduce both the variable costs per meal and the fixed costs.
